Too Taxing

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If accounting is full of gray areas, tax is a pea-soup fog. So it's no surprise that the most common material weaknesses revealed in the first round of Sarbanes-Oxley Section 404 filings are tax related.

For nearly one-third of the 488 filers that have thus far received adverse opinions on internal controls, tax accounting was listed as a contributing factor. According to Mark Cheffers, CEO of AuditAnalytics.com, the independent research firm that conducted the study, those numbers "could have been much bigger." There is a good possibility that many other companies just barely escaped the auditors' tax wrath, he says.

There are several reasons for this (see "Material Fallout" at the end of this article). First, tax professionals are in short supply. Second, Sarbox demands much more precision in tax-accounting procedures than has ever been required before. And because tax departments generally operated at a distance from the rest of the finance department, including internal audit, many companies had never before documented internal control procedures for tax.

"Tax accounting is its own little island," says Leslie Hauser, tax director for Wisconsin at Jefferson Wells, an internal-audit firm. Traditionally, she explains, internal audit and tax have operated independently. And if the two occupied the same room, she adds, they would disagree. Even external auditors, she says, would bring their own specialized tax auditors to evaluate a tax department.

Internal and external staff must communicate better if companies are going to avoid future adverse opinions. But more than compliance with the law is at stake. According to a study by independent research firm Glass, Lewis & Co. LLC, firms that report material weakness in tax accounting lose an average of 5.8 percent of their stock value 60 days after the announcement. In addition, says Cheffers, all but six of the companies in the AuditAnalytics study that received adverse opinions related to taxes had issued a tax-related restatement or a material year-end readjustment for 2004. In other words, he cautions, if you issue such a restatement or readjustment, be prepared for an adverse 404 opinion. "It will most likely become the standard," he adds.

The Evil of Estimating

Many of the adverse opinions so far can be attributed to the application of FAS 109, which governs the accounting for income taxes. Previously, says Timothy McCormally, executive director of the Tax Executives Institute (TEI), companies "had a lot more discretion." In fact, it was standard procedure to estimate tax obligations in the first three quarters, then "true up" the numbers at year-end. It was also routine, says Cheffers, to grab data from a variety of different sources (such as international subsidiaries) in order to prepare a "down-and-dirty tax estimation."

"It turns out some of that data was incorrect," adds Cheffers. Now companies are forced to take a more detailed approach and generate solid numbers each quarter based, for example, on how each deferred-tax position would unwind, and to which deals they should be attributed. Gross estimates are no longer acceptable, and procedures for gathering the data need to be codified. "All of a sudden we are moving from matters of judgment to matters of rules," says McCormally.

Applying specific rules takes time. Dynegy Inc., which received an adverse 404 opinion on its 2004 report due to a material weakness in tax accounting, knows the problem all too well. When the company began a deep analysis of its tax provisions in accordance with Sarbox requirements, CFO and executive vice president Nick J. Caruso and his staff realized that tax positions taken in earlier years were not adequately tracked. They discovered that the company had set aside too much in deferred taxes. "That's good information," he says, "but we then had to find out what caused [the discrepancy], and, thanks to Sarbanes, in which quarter."

As a result of the exercise, errors were identified and restated for pre-1999, 2001, 2002, and 2003, while adjustments were made to 2004 year-end figures. The good news: the company received a clean financial-audit opinion. The bad news: remediation of its tax-accounting systems and procedures had not been completed as of December 31, 2004, hence the adverse 404 opinion.

"I'm confident that we now have excellent controls in place," says Caruso. Dynegy has installed a new tax-software package — CorpTax ETS from Deloitte & Touche Technologies — to help it comply with Sarbox regulations and controls, and Caruso has added staff to the tax department to keep up with the "people-driven" nature of the new environment, which requires the company to keep a "complete set of tax books that allows us to keep up with depreciation from various acquisitions," says Caruso.

Shortage of Experts

Like Caruso, many CFOs are trying to beef up their tax departments in response to the increased scrutiny. Of the companies criticized for tax-accounting weakness, more than half blamed personnel deficiencies — lack of training, insufficient resources, and so forth. "I'm surprised [personnel issues] weren't listed in all of them," says Cheffers.

Part of the problem, says Hauser of Jefferson Wells, is that firms can no longer rely on their external auditors to provide guidance for complex tax computations or footnote disclosures. Now that the Public Company Accounting Oversight Board views such assistance as consulting, auditors can offer only limited tax advice to their audit clients, and many public companies now get their tax advice elsewhere. In a 2004 TEI study, 40 percent of companies surveyed said they had decreased use of their external audit firms for tax services since Sarbox was issued; another 11 percent completely refuse to use their audit firms for tax questions.

But hiring new tax accountants is not easy. Caruso, for example, says he was lucky to find five qualified tax people in Houston to add to his tax department. Kathleen Jennings, president and CEO of ET Search Inc., says, "I've never seen the pool so small." Tax professionals are leaving the profession, she says, because they know that "one mistake means somebody gets scapegoated." Eastman Kodak, for example, hired a new tax director in the wake of its adverse opinion, but wouldn't comment on the status of its previous tax director, citing a policy of not commenting on personnel matters.

Moreover, the traditional pipeline for tax accountants — the Big Four — is drying up, says Jennings, because some firms are locking in their talent by issuing lucrative mortgage loans with tough retainer stipulations as part of their compensation packages. While enrollment in accounting at U.S. colleges rose 17 percent from 2000 to 2003, enrollment for tax accounting is flat.

"It's not a path to the top," says Paul Sassano, tax-solutions director for Jefferson Wells. "People don't rise to CFO from the tax department." In fact, says Sassano, in many companies, tax is considered a lower rung on the finance ladder. "They feel a bit overlooked sometimes," he says.

A Fix for Tax

That may change. "Companies are going to view tax professionals as critical to the process from now on," says Jennings. Caruso agrees. "You have to put a priority on it, and tell them that it's good work," he says. "We gave [the new tax team] the message that we have a CFO who cares about the details and wants them analyzed."

Some companies are raising the profile of tax accounting by realigning the department and integrating tax professionals into business units. Some are installing a tax controller to serve as "interpreter" between tax and financial accounting functions. Others are focusing on the all-important communication between internal audit and tax. At Avery Dennison, for example, vice president Ahmed Rubaie now has both departments reporting to him, though the move was not prompted by 404 concerns.

How long tax accounting will remain in the auditors' grip is uncertain. "We are dealing with a swinging pendulum and trying to calibrate where it will take us," says TEI's McCormally, who believes many of the adverse opinions were caused by the suddenness with which the new tax rules were implemented. But Tony Santiago, president of TaxSearch Inc., sees little relief in sight. "Everyone is scared to death that one of the next areas of focus may be international FAS 109," he says.

Inevitably, there will be further repercussions. "Right now companies are balancing risk mitigation with tax planning," says Santiago. With the former winning out and given a zero tolerance for tax shelters, he says, companies will find it increasingly difficult to lower their effective tax rate. And, he says, "won't that put the CFO between a rock and a hard place?"

Kris Frieswick is a freelance writer based in Boston.

Material FalloutSome 152 companies have received adverse opinions on tax-related material weakness. Here is a sampling:

Company

Material Weakness

Outcome

AIG

Tax credits wrongly identified as insurance profits

Fired Mike Murphy (designated tax expert) and CFO Howard Smith

Kodak

"Errors, not misconduct" related to income-tax reporting led to informal SEC inquiry

Hired new chief tax officer in July and tax accounting manager in August

Tommy Hilfiger*

Alleged underpayment of Hong Kong taxes

Will lead to filing four years of amended U.S. federal income tax

MCI

"Significant complexity" in income-tax accounting

Hired more staff and a VP of tax and outsourced some tax areas

Impco Technologies

Calculation of the value of deferred tax assets

CFO and treasurer Nickolai Gerde resigned several weeks later

*Company expects adverse opinion.Source: Company documents and published reports

Combat Pay

FAS 109 and International Tax Specialists Are in High Demand

One of the side effects of improving tax departments is that tax professionals are seeing their stars — and their paychecks — rise.

According to Kathleen Jennings, president and CEO of La Jolla, California-based ET Search Inc., the simple rules of supply and demand dictate the terms. "Tax professionals have become highly specialized and there are fewer of them," she says. With the threat of an adverse opinion hanging over them, companies are becoming more willing to pay a premium for specific talent.

Among the specialists in hot demand are those who deal with FAS 109. They are the "new rock stars" in tax, says Tony Santiago, president of TaxSearch Inc. And they have seen their paychecks rise "anywhere from 20 to 50 percent in the past few years," says Jennings, who until recently operated the Website Taxsalarysurvey.com. The other beneficiaries are the international specialists. Those with 10 to 15 years' experience are earning base salaries of $150,000 to $200,000 and bonuses of up to 75 percent. Tax professionals are increasingly receiving signing bonuses and two-to-three-year guaranteed salary increases, she adds.

It is not clear how long the largesse will last, however. One of the traditional metrics for gauging a tax accountant's performance — improving effective tax rates — has essentially been eliminated. You can't tie bonuses to lowering tax rates any more, says Jennings. "It's just not considered ethical." Instead, she says, it might make sense to tie bonuses to keeping a company in compliance. "But really," she says, "how do you know you are in compliance?" — Lori Calabro